CoVenture Credit - Esoteric Credit with Ail Hamed, Brian Harwitt, and Marc Porzecanski - [Invest Like the Best, EP.108]

My guests this week are Ali Hamed, Brian Harwitt and Marc Porzecanski who work together at CoVenture Credit. When I first had Ali on as a podcast guest, we discussed the many aspects of what his firm does, ranging from venture, to crypto, to credit. We glossed over the lending side of the business, but having since learned a lot from them on the topic, I was excited to get the chance to talk with members of their credit team for today’s longer exploration of esoteric high yield lending. I am always proselytizing the value of investor education, s this week we have a podcast first. The CoVenture team has prepared a long series of posts that correspond to our conversation and go even deeper into the topic of credit investing. You can find them in the shownotes at investorfieldguide.com/credit This is entirely differently from any conversation I’ve shared before, so I hope you learn as much as I did. Please enjoy my discussion with team CoVenture Credit. For more episodes go to InvestorFieldGuide.com/podcast. Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub. Follow Patrick on Twitter at @patrick_oshag Show Notes 1:42 - (First Question) – The formation of their unique credit business 7:09 – Their advantage in seeing both the equity and credit side of their investments 10:23 – Looking at the Returnly deal as an example 14:07 – How they view these deals and are able to sustain them as long-term investments 18:09 – Their interest in payroll deduction lending 20:08 – Finding unique types of default risk 21:31 – What stands out in a platform that makes CoVenture want to take a deeper look 26:43 – Most interesting types of problem they have come across that they have yet to do a deal in 31:35 – What is going to change to make for more thoughtful underwriting of subprime lending 35:51 – Major structures of asset backed lending 39:49 – Whether the home serves as an interesting playground for credit opportunities and whether people will own anything again 42:44 – Mark’s experience working at a huge firm vs his experience at CoVenture 44:31 – How does the current credit cycle impact their view 47:04 – Lending against bitcoin 50:06 – Who is interested in these loans against bitcoin 50:57 – How to set interest rates against a weird asset like this 53:00 – What are the key determents of success in this business 1:02:27 – Kindest thing anyone has team for the team 1:03:52 – How to treat people that you pass on Learn More For more episodes go to InvestorFieldGuide.com/podcast. Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub Follow Patrick on twitter at @patrick_oshag

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Patrick O'Shaughnessy?

  I know firsthand how complex the tech stack is for asset management firms. And seemingly every new tool and data source makes the problem even worse, adding more complexity, more headcount and more risk. RidgeLine offers a better way forward. One unified platform that automates away the complexity across portfolio accounting, reconciliation, reporting, trading, compliance and more, all at scale. RidgeLine is revolutionizing investment management, helping ambitious firms scale faster, operate smarter and stay ahead of the curve. See what RidgeLine can unlock for your firm. Schedule a demo at ridgeline.ai.

• 0:36Patrick O'Shaughnessy?

  Hello and welcome, everyone. I'm Patrick O'Neal and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, methods, stories and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfieldguide.com.

• 0:57Speaker 02

  Patrick O'Neal is the CEO of O'Neal Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Neal Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Neal Asset Management may maintain positions in the securities discussed in this podcast.

• 1:22Patrick O'Shaughnessy?

  My guests this week are Ali Hamid, Brian Harwood and Mark Porzakansky, who work together at CoVenture Credit. When I first had Ali on as a podcast guest, we discussed the many aspects of what his firm does, ranging from venture to crypto to credit. We glossed over the lending side of the business, but having since learned a lot from them on the topic, I was excited to get a chance to talk with members of their credit team for today's longer exploration of esoteric high-yield lending. I'm always proselytizing the value of investor education, so this week we have a podcast first. The CoVenture team has prepared a long series of posts that correspond to our conversation and go even deeper into the topic of credit investing. You can find them in the show notes at investorfieldguide.com/credit. This is entirely different from any conversation I've shared before, so I hope you learn as much as I did.

• 2:07Patrick O'Shaughnessy?

  Please enjoy my discussion with Team CoVenture Credit.

• 2:14Patrick O'Shaughnessy?

  Well, thanks, guys, for doing this with me today. It's going to be a much deeper conversation, maybe than Ali and I had the first time he was on the podcast about a very specific part of co-venture, and that's unique or esoteric credit. This is almost the exact inverse of venture in many interesting ways, but is enhanced by the fact that you guys also play in the venture world. So maybe, Ali, you could just begin by framing this whole, we'll call it like a sub-asset class, why it's so interesting and why the sort of intersection of early-stage or venture and lending might represent an opportunity that most people aren't even aware of.

• 2:48Speaker 03

  Sure. And so, thank you so much for having us back on the podcast. And one of the things that we have been talking about before this is it's really easy to breeze over a certain type of investment thesis, but it's a lot more fun to like really dig in deep. And so hopefully, that's what we're able to do today. As a reminder, the way we ended up setting up our business and built co-venture in the beginning was we thought we were going to be a venture capital firm. And we were making equity investments in early-stage startups, but some of the startups that we were most interested in were in the alternative lending space. And the reason we were interested in that space is because we sort of saw this wave of lending 1.0, which was Lending Club, OnDeck, Prosper, SoFi, businesses that became really large, but primarily were taking loans that banks used to make offline and putting them online.

• 3:33Speaker 03

  And there was this huge promise of these lending 1.0 companies. They were going to lower the cost of origination so that they could decrease the loan size, lend where banks no longer could, and they were going to use data that other people weren't using to decrease default rates and price loans better. Not only that, they were then going to sell those loans to retail investors who, for the first time, were going to have access to yield that they never had access to before. The problem is almost none of that actually happened. The cost of origination didn't go down because as soon as everyone else realized it was a good idea, it became a flooded market and there was so much competition that the cost of acquiring a borrower went up. The second thing is, people would come to us and say, "Hey, I gathered 150 data points about our borrowers, and we're using these 150 data points to price our loans and lower default rates."

• 4:18Speaker 03

  And we'd say, "Wow, that's really exciting. Of the 150 data points, how many of them provide Signal?" And they were like, "Three." And we're like, "Okay." And like, one of them was FICO. And we're like, "Okay, great." And the last part is, the lenders on the platforms were mostly not individuals. So you ended up just going right back to institutions all over again. And this whole idea of democratizing yield just didn't exist in the way that everyone thought it would. So, look, I would have loved to been an angel investor or seed investor in some of these companies. Some of our partners actually personally have been, because they're worth hundreds of millions of dollars to a couple billion dollars now. But we thought the bigger opportunity and the longer-lasting opportunity was going to be new lending companies that were creating new credit products. These were credit products that had never existed before.

• 5:00Speaker 03

  And the way they were being invented was because you were finding technology companies that were, one, using their technology to observe a data point no one had ever observed before, that could meaningfully drop the default rate by an order of magnitude, not just 100 basis points. And, two, they would have a barrier to entry. The thing that gets us most excited in the world is when we find a technology company that's using its tech to invent a new type of credit, and where if everyone else in the world realized that that lender was doing what they were doing, they wouldn't be able to compete. And so, you know, there's a few examples of how you can create that barrier to entry. One of those examples is switching costs. So imagine you are lending through a POS system.

• 5:41Speaker 03

  And a lot of people have tried POS financing, but it's sort of an interesting concept in that, you know, let's imagine I go to a jewelry store and I say, "Hey, you know, Mr. Jeweler or Mrs. Jeweler, I'm going to start lending to all your customers who can't afford this necklace at once. And I'm going to lend to them at 20% APR." If a competitor came to them and said, "All in to your customers at 18% APR," we wouldn't get whipped out, because we're already in the POS system. If they said 15% APR, it would probably be the same. If we went to a small business and we said, "We're going to integrate with your POS system and we're going to lend to you at a floating rate based on how many customers came in this day, because if you have a lot of customers, you're a healthier business." And somebody else came and tried to rip us out of the POS system, they just wouldn't switch us out. And so that was a big barrier to entry that we got fascinated by.

• 6:25Speaker 03

  The second is, what's a data point that you can observe that no one else in the world can observe? We talked a little bit last time about produce pay, but I think it's a good example where what they've essentially done is built inventory technology that tracks shipments in real time and understands where produce is at any given moment so that they can finance it once it's on consignment. For them to get ripped out, you have to go to a distributor or a farmer and tell them, "Replace your inventory software and we'll start financing you." No one's ever going to do it because if they're charging X amount per shipment, 20 basis points isn't going to change their life as much as switching their inventory software. So that's a chance where we can observe data that no one else can observe. And the third is if it's a platform that can affect the outcome of the borrower. So let's imagine, and this is an example we haven't found yet, but we kind of love

• 7:10Speaker 03

  it to illustrate the point, if Amazon said, "Hey, we're going to start lending to the vendors on amazon.com." And if any of our vendors ever become late, we're going to tweak our recommendation algorithm to drive more traffic to that vendor so they'd suddenly make more revenue and can become current on the loan. So those are our versions of a unicorn. When we find a company that's using this technology to invent a new type of loan and has a barrier to entry where it can protect the yield so that what happened to Lending Club and OnDeck and all these other businesses doesn't happen to us, where all of a sudden our yields get compressed. So that was sort of the impetus of our credit business.

• 7:41Patrick O'Shaughnessy?

  Maybe talk just for a couple of minutes about the importance of seeing both the equity sometimes and then also being the credit in some of these deals. So I think what's interesting and will be the focus of our conversation today is underwriting credit, not underwriting the potential for a unicorn seed-stage equity investment or something like this. And as you've often pointed out to me, there really are inverse of one another. There's sort of uncapped upside and 1X downside on the equity side. On the credit side, like you know exactly sort of your max return for the most part, so it's really all about downside risk mitigation. But it seems as though a big part of your edge or advantage, if you will, to the extent there is one, is seeing both sides of this. So talk about kind of the early-stage component of this on top of those three things you just listed.

• 8:26Speaker 03

  Sure, so I'll start with a couple of things. The first is, in venture capital, your job is to make money, and in credit, your job is to not lose it. One of the first things I was ever told about venture capital was from this sort of ultra-successful VC. And he goes to me, he goes, "Look, if you invest in a company, the most you can ever lose is 1X. If you don't invest in a company, the most you can lose is infinity X. If you missed Uber, you missed infinity X." That is very different than what every credit underwriter in the world would ever think about. And venture capital is sort of this art, whereas credit is really a science. You know, I was going back and forth with somebody yesterday, and they said, "In venture capital, rarely is a portfolio made by your structure of a deal. In credit, your portfolio is almost always made by the structure of a deal." So there's so many differences between those two.

• 9:10Speaker 03

  And the third part is, the equity and the debt of a company are often inversely interesting. For example, if the equity of a company is to be ever-interesting, it means that it built a really, really big loan book, and traditional lenders will be able to come into the space and lend at a really, really low yield. Or, if the debt stays small, the loan book stays small, and your yield stays high, you never want it to be in the equity. It's a really difficult problem for us, when we're underwriting the company, to figure out, "Do we actually want warrants in this business, or should we just ask for a higher yield?" Often, it just makes sense for us to make a small equity investment in the business, or ask for no warrants at all, because what we're really trying to get is just sort of a higher bogey, because we believe a lot in the asset, as opposed to trying to be on both sides of the trade. In terms of the advantages of being in both,

• 9:53Speaker 03

  one of the things that you find for a firm like us is we face a lot more origination risk, and this is something that probably Mark will talk about and Brian will talk about in a moment, but we face more origination risk than other lenders, in that, when we fund a company, we have to decide, are they actually going to be able to attract borrowers? If I'm lending at 25% APR to super-prime borrowers, it's a pretty good credit product. I just don't know if I'll ever put any money out the door. I probably won't. And so, what we have to do is say, "Is there product-market fit here? And can we sort of think as a venture capitalist, in terms of, can this grow quickly?" And I think that's just a different skill set than most people in a traditional lending fund would have. The final thing is our deal flow is just different than everyone else. Our deal flow comes from the people we've co-invested with as venture capitalists or in spaces that we've developed a venture thesis.

• 10:38Speaker 03

  So the people who are referring deals to us are founders of tech companies, other venture capitalists, other people who are saying, I'll do the seed and series A of the equity if you do the debt. It's something that differentiates us from another credit business that might be cold inbounding to a bunch of borrowers who might be in a thesis that they like.

• 10:55Patrick O'Shaughnessy?

  Before we move on and certainly try to get Mark and Brian into the conversation, to talk about Returnly would be really interesting as an example, just because I think you mentioned already this potential accumulative data advantage that some of these companies can accrue over time that makes it very hard for competitors to keep up. That would be a great example just to frame this whole thing before we get into some of the deeper details on origination and sourcing and all these fascinating parts of this process. So maybe someone could kind of sum up what Returnly does and why that's interesting.

• 11:25Speaker 04

  Sure. So Returnly is a business that is a software business focused on providing returns management software to e-commerce platforms, mostly focused on middle market e-commerce businesses. And originally, what they would do is they just process your return, help the returner print out a FedEx label and handle the logistics surrounding that return. What they realized was if you offered an instant return to a shopper, you were actually able to increase the likelihood that they were going to purchase another item on that website by four times. And so what they began to do is offer instant refund at checkout, which began resembling factoring of that e-commerce return receivable

• 12:06Speaker 04

  in which as long as the borrower returned the original item that they had purchased, then Returnly had fronted the capital for the refund, the next purchase after the refund, and then gets paid back once that original item is received. And so an example here would be if I bought a $100 pair of shoes, I realized they were a size too big, so I said, all right, I want to return it, but you can get instant credit instead of having to wait for your refund to be processed. I then click it, I buy the shoes a size smaller, I print out the label, send the other shoes back, and when they were... Arrive back at the warehouse, Returnly then receives the money back that they had fronted to the ecommerce platform.

• 12:45Speaker 04

  So in this case, what they have, what Returnly has an advantage of that no other company would is they can see the returns behavior of different individuals. So this person has shopped at ecommerce store X, but they've also shopped at Y, Z, and all the other stores within the ecosystem. As they could say, are they a good returner? Are they a bad returner? Should we extend them the instant refund credit? Or should we not? And so that's a unique advantage that they have. Additionally, on the merchant side, they have the ability to access not only the sales information associated with the individual merchant. They have the returns data. So they can say, are people returning items en masse back to the store? And do we really want to be providing instant refunds to their customers? When we know that it's 60% of the items are going to be returned if we provide an instant refund, is that item going to be returned again?

• 13:30Speaker 04

  And then, you know, this is just a bad store to be in business with.

• 13:32Speaker 03

  And so it hits on the core thesis that we mentioned, which is no one has ever in the world provided ecommerce returns financing. The second thing is Returnly is the returns management system. So it's software as a service, which means it has switching costs, which is one of the great advantages of SaaS companies to begin with. So it's never like we're going to get ripped out. And the third is because the company is working with hundreds and hundreds of ecommerce companies. They know which customers in the world return stuff and which ones don't. I might not return something, not because I'm a bad person, but because I'm, you know, I've just, I've been to the post office, I never want to do it again.

• 14:03Speaker 04

  In building on that, not only is it on an individual basis, they can start categorizing by zip code, by, you know, different geographies on who are good returners and who are not good returners. So they're building out data algorithms based off of the hundreds of thousands of transactions. The company's already processed of these instant refunds, these micro loans in essence, they've processed over 200,000. And so they've gathered tremendous amounts of data around that. In addition to all the other transactions and returns that don't flow through the instant refund, just general returns that are processed by the company.

• 14:32Speaker 03

  So it's a new type of loan. They have data no one else in the world has and there's high switching costs. So that if anyone else tried to do it. They wouldn't be able to compete.

• 14:39Patrick O'Shaughnessy?

  Let's use those features as potential bugs. So how high of a turnover do you expect, let's say, looking forward five years, you'll have to have in terms of partners like a returnly, where the yields can remain this high? Because classic market stuff, you know, you see yields, certainly anything that's backed by anything that has yields in the high teens or 20 or, you know, some of the numbers that we've talked about in the past. And my first reaction is, well, like, that's going to have to come way down as it gets more stable. Do you think that that's true? Or do you think that some of these advantages, these, call them lending boats or something, are sufficiently strong that those kinds of returns on the credit side can can remain possible for, let's say, years to come?

• 15:20Speaker 05

  Yeah, so I think part of this is that we are getting paid for being transformational capital for these businesses. We're getting outsized risk-adjusted returns for being very early in a company's life cycle. So we are a provider of capital where others are not. I came from more traditional, larger asset managers where deals were being competed by dozens of parties. And as a result, yields were compressing massively. Here, we're one of very few people who are competing for these deals. And many times, we're finding opportunities on our own and being kind of the single party that they're talking to. And as a result, we're able to command yields that we think are good on a risk-adjusted basis, but that our borrowers are very excited to take because no one is providing capital to them.

• 16:05Patrick O'Shaughnessy?

  Does that imply, then, that, maybe I have it wrong in terms of how long they'll last, and it's more about how much you can actually push through? So the capacity of this style of thing, because the earlier stage is just much smaller than a, you know, a Fortress or a Blackstone or someone's going to get involved in?

• 16:19Speaker 05

  So if you think about us entering on kind of day one with some of these companies, a Fortress or a Blackstone probably doesn't want to be doing business with a company like this until they're at year three, four, or five. So I think there is sufficient time where we can command higher yields for that.

• 16:35Speaker 03

  And one of the things that was interesting to us, when Coventure started financing these businesses more from the credit side than the equity side, is we thought this was going to be sort of a hobby business or a side business that we would offer to our LPs. And we ended up seeing this sort of explosion of new types of credit. Our bottleneck is not necessarily deal flow. It's just we can only close so many deals at a time and do a good job of it. So I think that from a deal flow perspective, we think that this could be a pretty, a much bigger opportunity than we ever had imagined it, which is why we started bringing in a professional team and turning this into one of the core things that we really do. And then secondly, when we work with a company, we don't just say, hey, we're going to lend to you for as long as you're willing to let us lend. We kind of say, to Mark's point, we're transformational capital. We want to be the story of how you get built.

• 17:17Speaker 03

  And we want to be a part of every part of your capital stack along your maturity. So in the beginning, we're probably your only lender. Over time, you're going to want to de-risk your capital base by having multiple lenders. And so what we'll end up doing is saying, look, we're going to provide you capital now. In the exchange, we want to be able to lend to you for the next three to five years at a similar rate. And then eventually, you're going to have two lenders where you're going to originate assets. You're going to put them into two SPVs. We'll lend to one of them. The other lender will lend to the other. You're going to have a third party that sort of decides which assets go into which SPV. That way, there's no negative selection bias in each time. And then one day, you're going to raise bank financing. But the bank financing is going to have a really, really, really tight credit box. And we're going to be the one to always help you build that next product out. And if you think about a lot of the great lending companies today, they don't just do one product.

• 18:02Speaker 03

  They might have a different region, a different country, a different demographic, a different FICO score. And we expect our lending companies to do the same, where in year four, they're going to be experimenting with a credit product that we love, but still only has one year of data. And so while they might have bank financing for one of their products, we now have a relationship with the company where we're the preferred lender, because they already know what it's like to work with us. We happen to think that we're not the worst people on earth. And so we think that we can definitely exist with these companies in the next midterm, work with them extensively, even after they mature, on their newer products. And from a top of the funnel perspective, it's been really amazing to see. It's just like a renaissance of credit. It's cool.

• 18:42Patrick O'Shaughnessy?

  Just because this is something that's fairly unique, I want to get as many examples as possible to illustrate some of these points. We talked a little bit about produce pay, about returnally. I wonder if we could pause before getting into sort of the diligence process that you go through when you meet one of these new opportunities, with maybe one more example that you think well represents some of the ideas that we've talked about.

• 19:00Speaker 05

  Yeah, so another sector that we really like is something called payroll deduction lending. And so this is, not to be confused with payday lending, what it is, is it's lending to employees of large employers, where the loan repayment is actually withheld from their paycheck, in the same way that your health insurance premium or your taxes are. So you're top of the waterfall, so to speak, on someone's paycheck before it even hits their bank account. And what that means is that you're underwriting not the credit of the person themselves, but actually the likelihood that they're going to

• 19:32Patrick O'Shaughnessy?

  Remain employed.

• 19:33Speaker 05

  Remain employed, correct. So the the risk of default is that they're they leave or terminated. It still remains a loan of theirs, but you're not getting the same mechanism. And so one reason we really like this is because we see this as the leveling of the credit playing field. This is saying it doesn't matter whether you're a subprime borrower. As long as you're employed, your loan repayment is coming through like clockwork. And so it allows a subprime credit to perform like a prime credit. So that's something that we really like, and we're pursuing a lot of things in that space.

• 20:03Speaker 04

  And therefore reduces the cost of borrowing from, you know, payday loan level 100% APRs to significantly lower than that.

• 20:11Patrick O'Shaughnessy?

  So how how might that work? Like, what's the actual workflow then of the platform? So they're selling, I guess they're selling employers and the employers like it because it's like a perk that they can offer to their employees. Like, what's the incentive chain?

• 20:23Speaker 05

  Yeah, that's exactly right. So they sell it to the employer as an HR benefit. So they say, your employees can now have easy access to credit. They don't have to jump through many hoops. In fact, some of these guys don't even pull FICO scores or anything like that. It's just they lend you based on the fact that you're employed there.

• 20:40Patrick O'Shaughnessy?

  The example makes me think that maybe one key advantage here is finding like unique types of default risk and being able to underwrite them better.

• 20:50Speaker 03

  Absolutely, and that comes from a couple of ways. In this case, it's underwriting a new data point that other people haven't underwritten. So what you're doing is you're underwriting the employer's ability or inability to lay people off or fire people as opposed to underwriting the borrower's credit score. So you're literally underwriting a different data point. I'll keep driving it home. You have the switching costs by integrating with the payroll system so that no one's gonna ever rip you out. You have the identifying a different data point than anyone else was ever identifying before, which is underwriting the churn of the employer, not the credit risk of the employee. And you have a repayment mechanism that's really, really important that allows you to pull a percentage of their paycheck every couple of weeks. So it's essentially an annuity. And so you're able to lend to a borrowing base that would traditionally have to take,

• 21:35Speaker 03

  to Brian's point, payday loans, because it's just really hard to lend to them, A, at that size and B, at their traditional default rate, and make them microloans because you have a really cheap distribution channel and a really, really low default rate relative to that FICO band, which is not a 200 basis points improvement, it's an order of magnitude improvement, which is a really, really powerful thing. And so we love it because it's really good for the borrower, it's good for us, we think we're getting paid for doing something interesting, and it hits all of our checkboxes that we always look for.

• 22:03Patrick O'Shaughnessy?

  So let's dive now into, and again, as many of these similar stories as we can conjure throughout the conversation as examples, I think makes it easier to follow along with, into the diligence and sourcing and diligence process. So maybe since we've talked in the past about the venture capital, say founder archetypes, things that you might look for in an early stage like equity seed investment, use that as points of contrast to what you might instead be looking for that's unique or different when evaluating a platform. So you've mentioned already kind of how you see these things, which is from the venture part of the business, from your LPs, you've got a lot of unique places that you might get the original look at the deal. But once you've got something on the table that seems somewhat interesting, walk me through the diligence process. What is sort of the checklist

• 22:47Patrick O'Shaughnessy?

  that you need to see in order for you to do deeper work on a company or a platform?

• 22:51Speaker 04

  So definitely around the founding team, management team, to your point, what I think we really like and has been true for a lot of our founders is that they had previously worked in the industry that has lack of access to credit. So in the produce pay example, Pablo had came from a farming family and saw how difficult it was to finance his farm, and he saw that as a huge problem. For companies that we're looking at now, they're looking at financing healthcare insurance deductibles, and they come from hospital administration. They said, we're having a difficult time collecting on individual patient receivables. So people that have that sort of background, they understand the problem, they understand how to actually sell to those customers is really important and how to deliver that product. And then pairing that with someone who has the expertise of credit underwriting

• 23:36Speaker 04

  and maybe the more traditional credit background.

• 23:38Speaker 05

  Yeah, I think although we're dealing with new companies or emerging companies, what we're not going to sacrifice on is credit quality and helping that company define the credit box. So we can set parameters around what they're doing and the types of loans are originating. And so even though it may seem new, we're still putting kind of traditional bells and whistles around what they're doing. I think one of the toughest things to underwrite is actually their ability to scale. So one of the things where we're traditional lenders on the one hand, but we have to wear kind of a VC hat on the other hand, is can this company actually get to scale? Is it worth, because to us, doing a million dollar deal is the same as doing a $50 million deal in the sense of time and effort and energy expended.

• 24:21Speaker 05

  So we need to really make sure that what we're investing in is something that can grow to scale. And that's something that's really hard to underwrite. And so some of the features we work into our deals, for instance, like we can put a minimum utilization threshold in the deal, which means they have to be at least X percent drawn on the deal in six months or a year or whatever, or interest is owed as if it were, and that's a way to promote growth. Another thing we might do is actually lower the interest rate with the amount of dollars that have been deployed. So another incentive to try to get someone to scale.

• 24:53Speaker 04

  And then going back to the underwriting point, a lot of it is things that Ali has detailed before. What are the barriers to entry here? How can you maintain your yield? What is the underwriting that you're performing and how is it unique and different compared to someone else? How, you know, are you taking advantage of borrowers? We don't want to be in a situation in which we're providing financing to someone who's taking advantage of borrowers, which is why we like this payroll deduction model, because we feel like it's providing a significant benefit over working with payday lenders or other lenders of that type.

• 25:21Speaker 03

  Yeah, I mean, you know, I often joke when we're talking to our investors. We do all these really complicated things to come to a pretty simple end, which is Am I going to get like a mid to high teens yield and like a 1% default rate in a market that really, really needs this and would be willing to borrow from you? At the end of the day, that's really all we're doing. And there's a couple of ways to do it. The first is we can underwrite better with a new data point. We can originate better through a new distribution channel that's never been distributed through before. We can lower our costs so we can underwrite a really short duration receivable that a traditional lender can't underwrite. And it's got to be something with barriers to entry. If it hits those points, we can use all these really fancy mechanisms in the structure of the deal to, to Mark's point, make sure that they have to draw the capital and we get paid one way or another. Or we can work with them to define their credit box.

• 26:06Speaker 03

  Usually when a traditional lender will come in, they'll come in three or four years into the deal when the credit box is already defined. We're sitting there with them defining eligible loan criteria. That's a differentiator in what we do. So we're also looking for management teams that know their borrower well enough to know what they'd be willing to take, but also management teams that have a seasoned track record where we believe the eligible loan box we can come to together is really collaborative and sophisticated. One of the other things that Mark's sort of instilled in us from the years he's been doing this is when we underwrite a deal, we also have to say, if the originator goes bankrupt tomorrow, the day after we've closed, are we fine? You know, the two biggest risks of new companies is one, they don't originate, which we've already addressed. The second is the originator goes bankrupt, we might be secured by all the assets they

• 26:51Speaker 03

  originated that might be in an SPV or in our facility or otherwise. But are we actually able to go service those ourselves if we need to or employ someone who can go service those? So there's this checklist we go to through of, you know, are we going to get a reasonable yield and a really, really low default rate? And even if our models are wrong, there's a ton of wiggle room. And can they actually originate these loans? And in a worst case scenario, like are we going to sweat? And hopefully the answer is no.

• 27:15Patrick O'Shaughnessy?

  As you guys have described it, kind of like when you talk to early stage venture investors, there's this rise of interest in founders who have deep familiarity with their industry, like founder market fit is the term you always hear now. And I think what that gets at is a deep awareness and understanding of the problem at hand. A second key component, which you've kind of talked around is, I guess, answering the question like, why has Hasn't someone else dealt with this already? Like, is there just an insurmountable problem? That it may be a problem, but we can't fix it or we can't fix it right now? Thinking maybe one from each of you. What is the most interesting problem, specific problem? That you've come across that somebody's either trying to fix or that you're just personally aware of? That you have yet to do a deal in?

• 28:00Patrick O'Shaughnessy?

  So like, sort of a wish list, if you will, of the types of problems that this setup might solve?

• 28:05Speaker 04

  Yeah, so I alluded to a little bit earlier, but the interest healthcare insurance deductible financing. So what's happened now is there's 140 million Americans that have high deductible healthcare, healthcare policies. Which means that they have a thousand to $3,000 of deductible before they start receiving any benefit from their insurance. So what this creates is essentially a huge gap. And for a lot of people that are utilizing these high deductible plans is they can't afford that deductible. Now, nearly 50% of Americans can't afford a $400 emergency payment. And I think a lot of the people that are taking these high deductible healthcare plans fall in that. And so what you're seeing is there's a lot more receivables that are being serviced. Individual patients that are being serviced by hospital systems and healthcare providers. That are used to only working with insurance companies.

• 28:50Speaker 04

  You know, 90% of their receivables used to just be with insurance companies. And now with the rise of these high deductible healthcare plans, which has just been a function of it being more expensive for employers to provide health insurance to their employees. You're seeing a massive defaults across these individual patient medical receivables. And then these patients are forced to default on their receivables, which they don't want to do, which impacts their credit. And so what we're looking at and what we're interested in is finding a solution that's outside of payday lending for these individuals, which is often where they have to go to cover some of these payments. So we've seen a couple of different interesting ways of approaching this problem. One is through working with hospitals as essentially a billing and outsourced servicing and collections department.

• 29:33Speaker 04

  Paying on day one at a certain set discount that's negotiated between this company and the hospital system or the healthcare provider. And then providing a line of credit or a very affordable financing option to the borrower, the patient. And so instead of paying, you know, insane APR. Say I'll give you no, no interest and where you're able to get the economics is from negotiating a discount from the hospital and thereby lowering the potential default rates and still creating an interesting, attractive yield for a potential investor or capital provider. The other way of doing it would be more like an insurance model where an employer and employee pays a certain amount per month to have access to a credit line that's equal to the amount of their deductible and they have to, you know, if they have some sort of bill that they have to pay, they're able to access that line of credit at either no or little cost and then

• 30:18Speaker 04

  pay it down over, let's say, six, six, 12 months, 18 months, which we see as a tremendous alternative to a lot of people who are taking out payday loans to fill that gap. And so we've seen a number of different companies and are looking to partner one in the space that I think is approaching it pretty creatively.

• 30:34Patrick O'Shaughnessy?

  Fascinating. How about you, Mark?

• 30:35Speaker 05

  I think the access to credit for subprime borrower is still really lacking. You hear a lot about credit being freely available to folks, but it's really only prime credit. So when you think even about Lending Club or Prosper, which seems to be delivering loans to the masses, I mean, they still have minimum FICO score cutoffs of 660 or 680. So there's large swaths of the population that are being underbanked and, you know, you walk into a store like Best Buy or something and they, you can get 0% financing, but that's underwritten by an HSBC or Synchrony or someone who's providing, again, prime credit. So I think the, what's still left to, to happen is kind of the disintermediation of the payday or other industries.

• 31:16Speaker 05

  I mean, you think about payday, right? It's about a $50 billion a year industry. I think the statistic is there's more payday loan shops than there are McDonald's and Starbucks combined, which is just mind blowing. And so what I think there needs to be are new products. The payroll deduction is one, but for instance, point of sale financing, I think is another one that's going to be very large. So this is. Best buy financing for for folks who don't have access to the HSBC credit card. It's allowing them an option to purchase a refrigerator or something that they need, but at a subprime demographic. And so I think there's ways to address that. And I think that's going to be a huge industry because a lot of people who are taking payday loans are actually doing it to fill some sort of need.

• 32:00Speaker 05

  Their car broke down, their refrigerator did break. They need some sort of emergency medical expense. And I think we really need to address that.

• 32:07Patrick O'Shaughnessy?

  How might that happen? So it makes me think of this awesome line that Warren Buffett said to us, which is that price is his diligence. So if you think about payday lending as like having ridiculous yields or ridiculous, maybe they need to think less about the default risk just by pricing it appropriately with like a margin of safety, if you will, on the yield. What is going to change to allow more thoughtful underwriting of the subprime borrower? Like what what might be the unique data sets or data points that we've talked about as a key in all of this that that make this change from the system we have today?

• 32:39Speaker 05

  So I think you need an improvement in the structure of the loan to bring the default rates into something that is more normalized. So in payday, for example, default rates are really high, 30, 40, 50% even. And so what people don't like to talk about is the demographic who is taking out a payday loan, actually, you do need to charge them a high rate of interest. And the average person on the street thinks that, you know, 15% is a high rate of interest and that could be appropriate to a subprime borrower. You know, unfortunately, I don't think that's the case. I think they do need to pay a high rate of interest. But I think the way to get them off a payday level, which by the way, payday could be 500% interest or more. So I think the way to get them is through a structural fix.

• 33:23Speaker 05

  And so payroll deduction is one that's great because it levels the playing field. It introduces a mechanism that turns a subprime borrower into a prime borrower. If you think about point of sale financing or rent to own structures, that's also something that gets someone from a regular subprime loan into a more fluid repayment mechanism that gets them normalized. So you need to actually see a structural change in the way that the the product is being done as opposed to just. Lower rates, you need to actually improve the behavioral mechanism.

• 33:55Speaker 04

  And I think increasing financial literacy of our people in our country is also an important step here because most people walk by a store that says, "Get cash now, no background check required." They say, "Oh, great, I need cash." And they don't realize, when they're signing a contract, that they're essentially signing up to be in a debt cycle for, you know, in the indefinite future. And so I think part of, you know, part of to Mark's point is, is training people to avoid these debt cycles, which are often completely avoidable, but people don't have the resources or the knowledge to avoid them.

• 34:25Speaker 03

  And then, yeah, I'm gonna cheat, I'm not gonna use one, I'm just gonna go through a few of them quickly. And some of them touch hunt on prior Mark's points. You know, the two-week pay cycle is insane. The fact that we get paid, you know, every two weeks and the ADP gets annoyed at us that we wouldn't want to take our paycheck every day. It's like, that will not be a thing at some point. And so we're really fascinated about how do we factor receivables in that period, et cetera. To that second point, doing short-duration receivables is a really, really interesting thing to do online because traditionally, a bank or a brick-and-mortar can't originate a three-day loan because it'd be too expensive. That's why, that's part of why payday loans are so expensive. It's not just the default rates. It's that if I'm going to originate a two-week loan that's $500, you know, and I'm paying, you know, it's a brick-and-mortar, so I have to pay somebody minimum wage, which in New York is $15 an hour, and it takes them 20 minutes to originate the loan.

• 35:09Speaker 03

  It costs them $5 just paying that person to explain something to the borrower, not including the marketing, the brick-and-mortar, the real estate, everything else. And so if I were to start, charge state usury of about 25%, I would make like $4.13 of revenue on a loan that costed a minimum $5 to originate. And so the internet's amazing at originating short-duration loans, where you can handle the fact that as long as default rates are low, the total revenue on a loan is small. The other thing is, we value different things today than we used to. It used to be this common cliche in credit that you should lend against somebody's car because the car is the first payment they'll make. It's still one of the first payments they make. I care a lot more about my smartphone, though, than I do about my car. If you take my car, I'm gonna be really annoyed at you. If you take my smartphone from me, I will do horrible, horrible things.

• 35:54Speaker 03

  And so, you know, there's a company called Payjoy that we're not lenders to, but we applaud from afar. You know, they're helping people finance smartphone purchases. And they're secured by the smartphone. That's like a genius thing to do. And then maybe the last part is tomorrow's small businesses are different than today's small businesses. The great small business of tomorrow is not the drugstore on the corner. It's the Airbnb account. It's the e-commerce company. It's the Instagram handle, the things that we might have talked about last time. And so, we're looking at not yesterday's small businesses. We're looking at tomorrow's. And so, those are some of the broad themes that we like to kind of dig into.

• 36:24Patrick O'Shaughnessy?

  So, let's assume now that we've got, you've identified something. You're sort of comfortable with the major checkpoints. Let's call them that this might be somewhere with the capacity to put $50 million of your client's money to work in. And we're further down the spectrum here. We've referenced a few times how important structure then becomes. And we'll come back to some of the mitigation of downside risk. But certainly, structure is one way to mitigate downside risk when it comes to credit. Maybe you could touch on like the major structures. I'm thinking here about like forward flow agreements, ABL structures, things like that. Describe what those terms even mean, which I think a lot of people won't have heard those terms before. And how, kind of down to brass tacks, how these things are actually structured.

• 37:03Speaker 05

  Sure. So, there's two basic types of ways you can get involved in an asset, taking asset-level risk. One is a traditional ABL, which is basically, an ABL stands for asset-backed lending. And all that means is that you are lending to assets as opposed to a company. So, traditional credit, you're making a corporate loan to a company. In asset-backed lending, you are lending to the assets. The way you lend to an asset is you put it into a special purpose vehicle. You make that SPV bankruptcy remote. And in doing so, you are not taking the risk that the originating company is going to go bankrupt, you're just taking asset level risk.

• 37:42Speaker 05

  Another way you can get exposure to an asset is called a forward flow agreement whereby you are agreeing to purchase assets from an originator. So XYZ company makes loans, they then sell them to you on a forward flow basis and therefore you are buying these assets and you're going to wear the risk of the asset. And the way that it's different is that in the first case in the ABL, you're a secured lender and you typically have what's called over collateralization, meaning you're lending 90 cents on the dollar and so you have 10% of cushion. Whereas in a forward flow, you're actually buying the raw asset and so there's less cushion or no cushion in some cases.

• 38:23Speaker 05

  And so typically, the pros and cons are you're getting paid more in a forward flow, you're just yielding more, but you have fewer kind of protections from a structural perspective.

• 38:34Speaker 03

  One of the roles that we play is almost as an educator of these lending platforms because for a lot of them, we might be the first lender they've ever had. And so we help them figure out what do they really want? And so many people, the first thing they ask is what is the rate of return that I'm going to have to give up for the money? That might be like the third most important term of the deal. So in a forward flow agreement, you're selling the assets that you originate to a lender at a high price, but at least you don't have to understand how many loans you're going to originate that month. Startups are like, you know, just notoriously bad at projections. And if you're a startup that doesn't know if it's going to originate $100 or $200 or $300 next month, it's really good to have a forward flow agreement so that you can sell, take that burden of cash drag and put it on your lender. Some funds can do it, some funds can't.

• 39:17Speaker 03

  If you're doing it in an ABL facility, what you do is you originate a loan, you put it into the SPV and you're usually guaranteeing some rate of return. God forbid you don't originate as many loans as you thought you were going to. You owe money on assets that aren't even yielding you any revenue. And so there's pluses and minuses on our side. There's also pluses and minuses on the originator's side. And one of the things that we try to do is introduce the originators we work with to other people who have built big lending companies so that we're not the only people giving them advice. That way, they can kind of triangulate what other firms have done in the past and sort of the advantages.

• 39:49Speaker 05

  Also, the deal structure is driven also by what the originator wants to look like. So if they want to be an on-balance-sheet finance company, they'll choose an ABL structure. If they want to be an asset-light fintech company, they'll choose to engage in forward-flow purchase agreements because that way, they don't have the assets on their balance sheet and they can try to look more like a technology company that the goal is to trade at a higher multiple essentially by being asset-light.

• 40:16Patrick O'Shaughnessy?

  Which is what a Square is doing with their merchant cash advances. They're selling them in forward-flow manner. One of the common themes lately and just in people I've been talking to is this idea of like home services, things having to do with the home that are critical. You mentioned refrigerator earlier, which makes me think of like HVAC. And like lending against, you know, HVAC installations where the asset is, you know, you go rip the thing out of the house. I've got friends who have certainly been involved in this sort of lending before. And that seems like something that is very critical to a person's life, but also seems maybe like a little bit more traditional, you know? That's something that maybe has been around, I don't know. I'm curious your take on this idea of the home as an interesting like playground for credit opportunities.

• 40:58Speaker 03

  I think that what's interesting is, I don't think anyone's going to own anything anymore. So we have two founders, one's 30, one's 40. The 40-year-old was talking about a car he owns, and the 30-year-old looks at him and he goes, "That's so Gen X of you to own a car." You know, I thought that was a hilarious comment, but it's true. So, you know, I think I'm going to like lease everything that I'll ever have. I don't even know if I'm ever going to own a home. Like, there's all these nomadic living places where you can pay, you know, one month's rent but have access to a place in Berlin, Miami, New York and like...

• 41:24Patrick O'Shaughnessy?

  Ali, you clearly don't have any kids.

• 41:27Speaker 03

  Sure. This thesis may evolve. But I do think that that's sort of an interesting concept of people are going to live in places for less time than they used to live, so why own the asset? And there might be an ability to lend against them. One of the problems that we've seen, so we've seen a lot of these furniture companies are saying, you should rent your furniture, not own your furniture. These companies are just basically lending companies where I give you a couch. I assume that you're going to pay me once a month for that couch, but God forbid you don't pay the loan. I'm not going to come to your home and try to take the couch. It sounds really expensive. So if I'm lending against an $800 asset, it's really hard for me to make the economics of that business work because what you're doing, like your core competency of that company is actually to be a collections business. You're not underwriting necessarily better. You're not able to secure against an asset in like a way that's structurally different.

• 42:11Speaker 03

  You just have to find a really, really cheap way to collect in the event that the person doesn't pay you because that's ultimately where a lot of those things will break down. We've seen a lot of these HVAC, you know, borrowing businesses or lending businesses in our world of what we think is niche, that's like super mainstream. And I'm sure, you know, for many people that is niche and is pretty esoteric, but we've just seen yields because too many people are in that space that are in the, you know, high single digits in 10, 11, which just isn't interesting enough to us if we can do 15, 16, 17 at 1% default rates.

• 42:39Speaker 05

  I think you do want to lend to assets that have high use cases. So HVAC is a good example. Refrigerator is a good example. Things where you don't want to lend against are things like vacations or something where once it has occurred, there's really little incentive to repay, but a refrigerator right that you continue to use or your HVAC you continue to use. I've even seen a company once that was leasing pets. So the idea being that you have such a high emotional affinity to your pet.

• 43:07Patrick O'Shaughnessy?

  Sure.

• 43:07Speaker 05

  That the likelihood of you defaulting is so low, right? So.

• 43:10Speaker 03

  I would love to see you run a collection process.

• 43:14Speaker 03

  Mark is way too nice of a guy to do that deal.

• 43:16Patrick O'Shaughnessy?

  Mark, it's an interesting opportunity, given your background and maybe you could, you could touch on what you were doing prior to co-venture. Just to ask your opinion more generally speaking on, I guess, like the macroeconomic situation that we're in today, maybe draw some points of contrast between working at a massive business versus a very small one and the sort of credit opportunities being pursued by, you know, huge scaled up organizations and kind of what that landscape looks like today.

• 43:41Speaker 05

  Sure. So I started at Credit Suisse and then was at Angelo Gordon and Ares. And I think the, what we were looking at at those organizations were assets that could scale into the hundreds of millions. Or really, we're starting at that, at that point. And so what that lends itself to are, you know, opportunities where you're dealing with assets that have been in existence for decades. And you're dealing with originating companies that have years and years of experience. And you have tons and tons of data and you know with certainty how these assets are going to perform. What that means is you've de-risked a lot. As a result, your yields are going to be low because there's so many people who can then underwrite that risk.

• 44:26Speaker 05

  What that means is that a lot of opportunities are overlooked where it's a fledgling company. But we know what they're doing. We can still get under the hood and underwrite the credit box. And so that's what we're really looking at at CoVenture are all the things that are falling through the cracks. Because they don't meet the criteria of, you can immediately deploy 50 million bucks. You can immediately put money into an originator that has 10 years of experience. Or that has originated tens of millions of assets. So we're looking at those opportunities where we feel like we're getting outsized risk adjusted returns. Because we're new to, to that company.

• 45:03Patrick O'Shaughnessy?

  How do you think about adjusting your behavior relative to like your view on the credit cycle? Like where we are in a credit cycle? Does that matter more at the higher scale than it does down in what I'll call like more idiosyncratic? Type stuff that you're dealing with now? Talk a little bit about your, your view there.

• 45:20Speaker 05

  Yeah. So when you're lending against assets, what you really want to do is lend against the asset. You don't want to have to take a macroeconomic view. So there's two ways to do this. One is to lend against really short duration assets. So Produce Pay, for example, is a 30 to 40 day asset. Returnly, we were talking about earlier, is a 14 day asset. Other things that we look at are maybe a year or two tops. And so those short duration assets, because they're so short duration, you don't have to take a five year view in the economy. So that's one way to deal with it. Another way is to find uncorrelated assets. The most uncorrelated asset I've ever seen is actually a pharmaceutical royalty.

• 46:01Speaker 05

  So this is a situation where you're buying a piece of a deal that's, for example, a multiple sclerosis drug or a leukemia treatment drug. These drugs are medically necessary. You have to take them in order to continue your way of living. And as a result, if you look at the data through the crisis of how these drugs sell and perform, it's completely like clockwork. I mean, and so you try to find these assets that are completely market neutral. So that's the other way of taking longer duration risk, but in a way that's completely mitigated.

• 46:33Speaker 03

  Another, one of the things that we think about in terms of trying to mitigate lending against an asset and why we feel like it would be less correlated is, one, if it's a short duration asset and we're pricing that asset, let's say 30 days before we expect to get repaid and we're lending at 50% LTV, we're able to take the tolerance of, do we believe that that asset is going to crash 50% within 30 days? And so what someone might be thinking is, okay, so I thought the mortgage crisis was lending against assets. Why is it not the same? You know, those were 95, 97% LTV loans that were taking years and years and years to pay off. If we are able to finance a 15, 30, 45, 60 day asset at 60% LTV, you know, it's not perfect. Orders of magnitude better than just unsecured consumer lending or auto lending, which is,

• 47:17Speaker 03

  you know, I'll lend at 90% LTV against the car and then as soon as you drive it off the lot because depreciation is nonlinear, you're suddenly underwater. So it's a lot of those also nuances that make sure, you know, not all asset backed lending is created equal. Short duration, low LTV, all those different things are super important in terms of making sure you're actually adhering to that less correlated to the economy.

• 47:36Patrick O'Shaughnessy?

  So I can always rely on you guys to be doing interesting things. So I have to ask a little bit about the background on lending against Bitcoin. Maybe you can describe what's going on there and why that's interesting.

• 47:45Speaker 03

  I want to let Mark describe this one because, you know, Mark comes from this sort of structured credit background where on his first day at co-venture, he was wearing a suit. We've knocked that out of him. And then we put him next to Nikhil, who's our head at crypto. And Mark comes up to me, he's like, what's stellar? You know, like, I thought there was only Bitcoin and Ethereum. So the idea that we've actually convinced Mark that lending against Bitcoin is a good idea. It's really phenomenal. I mean, it's a huge inflection point in co-ventures history. So I'll let Mark kind of pitch this because you were probably the biggest bear going into it.

• 48:17Speaker 05

  Yes, all that is true. And I will say, I would have never thought I'd find myself in a situation where we're actually going to be lending against Bitcoin. So it's quite a change. But what's interesting is it bears all the hallmarks of a good asset to lend against because you have mark-to-market pricing on a 24-hour basis, and you have the ability to custody the Bitcoin in your own wallet. And then you have the ability to sell it instantaneously if there's a margin call. And so what this essentially is, is margin lending against Bitcoin. And so if someone makes a 50-LTV loan, so if you have $100 of Bitcoin, they lend you $50. And then if things get so out of whack that it now reaches a certain

• 49:01Speaker 05

  level, they basically will margin call you. And if you're unable to satisfy the margin call, they'll liquidate your position. And they have the ability to do that 24 hours a day. And in that way, and since they're holding physical custody of the Bitcoin, you have a pretty impenetrable way to secure the collateral and sell it. And so, like I said, I would have never thought we'd be looking at this. But it bears the hallmark of a liquid asset. And you know, that's one of the things we've analyzed is what is the liquidity of the market? What is your ability to get out of the asset? How much of volatility spike could you sustain before suffering a loss in a situation like this? And so it's a really interesting opportunity and something that we're looking at closely.

• 49:45Speaker 04

  And a lot easier to collect on than a couch. And divisible and all sorts of things that make it more attractive to lend against.

• 49:50Speaker 03

  Yeah, it's actually really funny. So a lot of the stuff we do, people look at it and they're like, wow, this is super funky and weird. It's actually less weird and less hard. If you're trying to take a levered position to try to eke out a certain yield, that's a lot harder to do in underwrite than just lending against an asset that most LPs would look at like sort of funny. A traditional lender, their issue is, no matter how rational it is to lend against Bitcoin, god forbid you ever lost money on it. They'd be like, well, of course, it was Bitcoin. And they'd look at you funny even before you started doing the deal. Our LPs, when they talk to us, they just assume that we were going to do it from the beginning. The Venn diagram of people who have a crypto business and an asset-backed lending business is like super narrow. And so that's part of what earns us the yields we get. It's not that we're just being way smarter than everyone else. To Mark's point, it's an obvious asset to finance.

• 50:35Speaker 03

  It's just that we have a different LP base that expects certain things of us.

• 50:38Patrick O'Shaughnessy?

  So two more questions in light of our conversation so far. The first is on the origination side. So talking to you a little bit about that, like who is trying to borrow again? Like where's the demand for this? And how is that part being handled? Like, what's the capacity of this idea?

• 50:51Speaker 05

  So the demand is coming from a mix of parties. It could be an individual who has seen a rise in their Bitcoin asset, and therefore they're looking to take off some liquidity, some chips off the table, but in a way that is a non-taxable event. Or you could see a company, it could be a mining company, or it could be a hedge fund that is basically looking to lever or, again, create liquidity. So those are the main opportunities that we're seeing. And what's fundamentally, the belief is that the rate of return on the underlying Bitcoin will be greater than the interest rate that they're paying, so they're willing to do it.

• 51:26Speaker 03

  And Patrick, I hear you have some Bitcoin, you know, if you ever want to borrow from us.

• 51:29Patrick O'Shaughnessy?

  I'll let you know.

• 51:30Speaker 03

  We're happy to give you a friend and family rate.

• 51:32Patrick O'Shaughnessy?

  So talk to me about how to determine the rate of interest on something like this. So I'm just thinking about, I don't know when it was, a week ago or two weeks ago, when there was this like almost bug that got into the code that could have done, you know, God knows what. And there's sort of like this sword hanging over this whole thing that it seems to have been remarkably secure, which is why it's so interesting. But you just don't know, right? It's software. So how do you think about setting interest rates and price relative to sort of a weird risk profile?

• 52:00Speaker 03

  Let me just start. I'll let Mark give a more sophisticated and detailed answer. We're of the view that Bitcoin's going to be around. And one of the best ways to test that is the fact that it's had a really big bounty on its head for a long time. And if it was going to break, it probably would have broken by now. There's a lot of really motivated individuals. Now, sure, there's going to be bugs, but there's enough of a developer community around it where I don't know if it's going to be $20,000, $5,000, $10,000, $100,000. And I hope it's $100,000 because I'll have a much nicer apartment if it does. We're of the view that it is going to be a thing. And there is enough of, you know, I think structuring it in a way where there's the way for that variance with the right LTV and the right liquidation terms sort of helps with the pricing.

• 52:39Speaker 04

  So I think right now, the pricing is less sophisticated than it should be because it's more a function of supply and demand is who's actually going to be on the lending side of this transaction and what's the rate of return that they're requiring versus how many people are actually asking for this. And right now, what we're seeing is I think there's a higher amount of demand for these loans than there is supply of institutional capital to actually to provide these loans. And so that's what's driven the rate of return so high at this point in time. You know, you're seeing-

• 53:06Patrick O'Shaughnessy?

  Can you share what like roughly ballpark?

• 53:08Speaker 04

  Yeah, so you're seeing anywhere between 12 and 25% for APRs for this asset.

• 53:13Speaker 05

  To me, if you off the cuff ask me for an interest rate for an asset like this where there's fairly few people willing to lend against it, that should be like a high teens rate of return. I mean, because I've heard some people say, oh, yeah, Bitcoin's such a liquid asset, it should be like 8 to 10%. It just intuitively feels too low for something like this.

• 53:32Patrick O'Shaughnessy?

  Fascinating. What have we missed in terms of the key determinants of success in this style of investing? I feel like we've done a pretty good job covering the things that you look for that make what kind of we've referred to as lending 2.0, trying to deliver on the promise of these original online platforms that didn't really come to fruition. So we've talked a lot about like the specific characteristics that you look for. Have we missed anything major that you think is important to cover?

• 53:56Speaker 03

  So one of the things that people always do when they talk about investing is every moment up until you've actually closed the transaction, but probably 60% of great investing is everything that happens after you close the transaction. It's the monitoring, it's the portfolio support, it's the making sure they actually do what they said they were going to do. We will get [bleeped] by somebody at some point and knowing how we're going to get [bleeped] and defending against it before they try it, being in control of the cash. So, you know, I think, Brian, it might make sense for you to kind of talk about when we're modeling something, how much variance we give to what we think is going to happen and what could happen before we're out of the money. And then also just sort of the monitoring, the portfolio, the on sites that we do, the spot checks that we do, why UCC ones are ridiculously stupid, you know, things to rely on, everything else.

• 54:40Speaker 04

  Yeah. So, you know, when going back, touching on our underwriting conversation, when we're looking and building out a credit model- We're really trying to understand what's the default rates within the asset base that we can incur before loss of principal, loss of income. And that's critically important. So we do that by building out cash flows of those underlying assets, projecting in a variety of default rates, building a sensitivity, and then comparing that to some sort of base case assumption for default. So if there is historical data from the company, we'll look at that. If not, or if that's not robust enough, we'll look at proxy data. So other data for small business lending, consumer lending within that space. And then we're able to come up with a multiple on loss coverage. We say, based off our base case of 5% default rate, and it looks like here we can sustain

• 55:24Speaker 04

  10% before loss of income, we have a 2X coverage multiple. And now for our deals, we typically say 2 to 7X, just depending on how much historical data, how much volatility in the asset class we believe. And then throughout the investment period, as Ali's alluding to, monitoring is critically important. So every month, we're receiving a portfolio tape from our different platforms that says, here are all the different receivables we have right now, here's the performance. And then we can look at that and say, how is that compared to where we projected? Should we change our base case default assumptions? And do we need to rethink anything about this investment? And that goes beyond just the portfolio as well. For Ali's point, there's a million different ways to lose money in this business. It's about making sure that they're complying with every covenant. And Ali likes to say that's getting [BLEEP], but I think we like to say covenant compliance

• 56:09Speaker 04

  is the more appropriate word of calling it. And so making sure that everything is going well and doing consistent checkups with the businesses that we're working with, doing on sites to catch anything that might slip through the cracks, otherwise just looking at Excel file.

• 56:23Speaker 03

  Yeah, and part of it's also getting smart in the very beginning of the deal via either having termination triggers based on performance. So you say, hey, look, our base case here is 5%. We can incur a 14%, 15% default rate before we lose any income and 30% before we lose any principal, including numbers from the actual deal we've done. They had good enough data where we felt like that was a reasonable loss coverage ratio. As soon as they get to 8% default rates, we stop funding. At 12% default rates, we default on the loan and just start collecting receivables. So a lot of it is making sure that in the beginning of the deal, we get in front of those scenarios where if things are going a little bit sideways, we don't have to keep lending. And the second is also just making sure the borrowing base makes sense. So there's another facility where, and you'll see this in a lot of facilities, where we say,

• 57:06Speaker 03

  "Look, we're going to lend you $90, but we need $100 of good assets. In the event that, you know, five of those dollars of assets go bad, you either need to contribute new good assets in there or put your own cash from your balance sheet, otherwise we won't keep lending." So a lot of it is having the tools and the terms so if while you're monitoring something, things go awry, you can immediately act on it. And then a lot of it's also expectation setting. Venture capital is probably my favorite asset class to be a part of, but it's also the one I like to, you know, talk trash about the most. VCs just don't really do a lot of monitoring and support of companies and don't, they're just really nice guys. Everyone's sort of founder friendly, everyone's this, everyone's that. In credit, you don't have that same luxury because you don't have the opportunity to earn it 30 times multiple.

• 57:48Speaker 03

  And so we have to tell them ahead of time, you know, this term is in the document. If you breach it, we're actually going to enforce. So just be ready ahead of time because what we don't want is a surprise. One of the things that was one of my biggest learnings in investing, and I think we've all kind of learned, I used to think it was a really good thing when I knew more than the borrower about the deal. You know, in my head, I'd think, well, we've done a ton of these things and I'm able to negotiate the document better than they're able to negotiate it. And so inevitably I'll come out as a winner. If we negotiate a deal that the other party doesn't understand and they breach something they didn't realize they breached, and then all of a sudden we screw them for it, something's going to go wrong. And so a lot of it's just education about it. Say, "Hey, look, these are all the covenants. This is what the agenda is going to be on the onsite." You know, of course, we have to surprise them on certain things because there's audits

• 58:33Speaker 03

  and everything else. But a lot of it's just sort of having this good firm, but reasonable bedside manner with the company where they understand the deal they've gotten into and understand how we're going to act when things go wrong.

• 58:43Speaker 04

  Yeah, and so to touch on your point again, documentation, which is a part of the structuring, is incredibly important per Ali's point there. And also, you know, constructing the borrowing base that Ali was talking about. So making sure if you think you're collateralized by $100 of assets, that it's actually $100 of assets. So for example, if you say, "I'm going to lend $80 against a portfolio of loans and there's $100 of cars in it," when you actually have to go collect on those vehicles, is it really worth $100? Or is that actually after, you know, the auction value? And hiring a skip tracer to go find the cars is at $50. So making sure that you're actually properly collateralized. And then to Ali's point again about educating the borrowers who are, you know, early-stage companies that don't always have the sophistication from a structured credit perspective is walking through the key terms, not trying to hide anything,

• 59:26Speaker 04

  making sure saying, hey, this is the, this borrowing-based concept, this is what I'm going to expect from you every month. This is what you need to report to me. Is this realistic? And, and walking through like that, and we like to consider ourselves sort of training wheels before they eventually go on to a bigger and badder facility where the, you know, the chances of their face getting ripped off are a little bit higher. And so I, I think that's, that's one way we like to look at it.

• 59:48Speaker 05

  And then I would just add that you need to make sure you've thought through every possible risk. So there's a lot of hidden risks in these deals. So just two examples that come to mind. One is we've seen a lot of deals where there's some really cool piece of technology or equipment that's going to be, and the deal sounds great, right? It's going to be leased on long-term leases to investment-grade companies. And the technology's awesome. It saves them all this money. And, you know, what could go wrong, right? Well, what could go wrong is that the technology actually doesn't work or it conks out in year three. And all of a sudden, then the lease is cancelable and the whole thing just falls apart. But that's not something that maybe was obvious in, in day one. Or another example of something is I've looked a couple of times at lending against art,

• 1:00:31Speaker 05

  which sounds really cool, like, oh, you have a $50 million Picasso. Why wouldn't you lend 25 million against it? And the deal sounds great. We'll, we'll give it to you so you're physically holding it in a secure vault. What could go wrong? Well, what could actually go, and it's insured. So it sounds great. Well, it turns out that you can't get insurance against fraud. So if it turns out that the Picasso is a fake, the whole thing just blows up. Your collateral is worthless. And there's actually no good way to verify that the art is legitimate. You can only rely on a letter from the estate of Picasso to tell you that it was authentic. But that's not really good from a chain of custody perspective or title perspective. So there's a lot of risks that seem obvious when you think about it, but when the deal is presented are just not there.

• 1:01:16Patrick O'Shaughnessy?

  It sounds like it kind of pays to be a pessimist in many ways in, in this world versus the more optimistic venture capital setting.

• 1:01:22Speaker 03

  I, I grew up with a, like a very worried mother. And so, you know, that's sort of been a great positive in my investing career. You know, the other thing is also like, what are the things that are either false posers, things that are assumed to be true? You know, one of the things that I, it actually a borrower. Came to us a long time ago about, and we've always repeated it, is the UCC is like one of the great falsities of lending. You know, a lot of people say, oh, my security interest is perfected because I have a UCC. That's basically self-reported data from small businesses. Like, how good is that probably going to be? Probably not that great. The other is, you know, Brian was bringing up earlier when we were on our way over here, insurance policies. And people say, oh, that asset's insured. What percent of lenders are actually reading that insurance policy all the way through? Hopefully, most, but there's going to be someone out there who isn't. And they just say, oh, it's an insured

• 1:02:05Speaker 03

  product, great. Or when it's a get renewed, stupid stuff like that. So there's a lot of things that people sort of take for granted, and those are the things that are the easiest to overlook. Or you say, oh, don't worry about it. It's this. Oh, we have a backup servicer is another great one. Hey, we're lending against these assets. Who cares if the originator goes bust because we have first associates as our backup servicer? Everyone has first associates as their backup servicer. And so in the next credit crisis, they're probably going to be really busy. Unless our loan book is big enough to get their attention, like, we're not Morgan Stanley. And so first associates probably going to go service their biggest customers in a time of crisis. And so just stuff like that where you kind of hear in every deal, oh, don't worry, we're using this firm, or this is the vendor for this. You kind of have to be critical about all the things everyone assumes are okay or easy.

• 1:02:49Patrick O'Shaughnessy?

  Well, this has been awesome. You know, really great overview of something that's different from what I usually cover. I'm such an equity person at heart that talking about credit's been really interesting. I've already done this with Ali, and maybe you guys know this is coming, but I like to ask everybody at the end of these conversations for the kindest thing that anyone's ever done. And we can start with whoever's ready.

• 1:03:09Speaker 04

  We've discussed this in the opposite leg, and we both were struggling to go outside of our parents, which is, I know, a cliche answer, but is that an acceptable one? Who's the borrower who paid us back fastest?

• 1:03:22Patrick O'Shaughnessy?

  You can do anything you'd like.

• 1:03:23Speaker 04

  I know this sounds incredibly cliche, but it really has to be my parents, who, as I've reached my adult years, I realize how much they sacrificed and how much they really have put me ahead of themselves in so many scenarios and afforded me so many incredible opportunities to put me in the place where I am today. So I'm forever grateful for them and then for their parents who put them in similar situations to succeed.

• 1:03:46Speaker 05

  I would say, you know, obviously, my parents have helped me a lot. I was very fortunate, when I started my career in investment banking, to have three bosses, Russ, Chuck, and Steve, who really took the time to teach me finance. And I think that has been

• 1:04:03Speaker 05

  The greatest single learning, because a lot of people go through investment banking and it's kind of a machine and you know, they don't, no one really mentors them or takes the time to teach them, you know, more than just the spreadsheet they're working on or whatever, sometimes don't even do that. So I was very fortunate to have kind of actual mentorship and people who taught me the trade and how everything works.

• 1:04:23Patrick O'Shaughnessy?

  Ollie, just one closing thought, which I thought was neat as we were going back and forth in preparation for this. Maybe you could just discuss this idea of how to treat people that you ultimately pass on. I thought that that was like a really interesting idea when it comes to sourcing and would be a nice place to close.

• 1:04:40Speaker 03

  Sure, so you know, we probably see, let's call it, when we really turn on a couple hundred deals a month across the firm, and that means that we probably are going to talk to 2,400 founders each year. The best marketing tool we have, okay, so of the 2,400, we might do 12 deals. So that means that we have, you know, 2,388 people who are fairly annoyed at us. The best marketing tool we have is those people that we passed on. And so it's our job to, no matter what happens, create an incredibly positive experience. One of the things that we were inspired by, we have a, we had a company that was pitching Sequoia, and Sequoia ended up passing, but what Sequoia did is they said, hey, export all your data and send it to us. And they had a team of data scientists actually go through all the data, the cohort analysis, everything else.

• 1:05:25Speaker 03

  And then they sent back the investment memo to the founder and said, here's all the things that we analyzed, here's the things that you could do better, here's things that companies in our portfolio have done that have helped them grow faster, and we think these are things that you should implement within your own business. We will always send, I mean, it's Sequoia, so of course you send deals to them, but like, for a business that's already that great, to have that kind of experience with the founder they passed on is a really, really powerful thing. We try to have something close to that with the founders that get pitched to us. You'll never hear us say, oh, it's too early for us, but thanks. That's usually sort of a nice way to say, I don't want to tell you exactly why I'm passing. What we try to do is be very, very specific, just like you would do when you're managing one of your employees, Patrick. If someone does something wrong, you don't say you suck, you say, this is specifically what happened, and these are ways that you can make it better.

• 1:06:09Speaker 03

  We try to do that with the founders, so that no matter what happens after that, they feel excited to send one of their friends to us. It's a differentiator, it's got an order of magnitude difference in terms of how we market, and I'd say probably a third of our deals comes through that channel, which is flattering to us and exciting.

• 1:06:25Speaker 04

  And specifically this week, we saw three deals that had come from previous founders that we had passed on. And it's just literally just this week. And a lot of what we like to do is we, you say, hey, if this is not the right opportunity for us, we're happy to help advise you as you raise capital and say, we'll look at your term sheet, we'll help you think this through. You know, just because we feel like it's, as Ollie mentioned, it's really important to build out our reputation within this ecosystem. And we consistently see deals coming back from different founders.

• 1:06:52Patrick O'Shaughnessy?

  There's a high return on goodwill.

• 1:06:53Speaker 04

  Yeah.

• 1:06:54Speaker 03

  And you have the same thing. You know, when you meet somebody interesting, you almost have, you feel like you have this internal obligation to connect them with someone else to get along with. And you probably have this like little spark in your head where you're like, wow, that's gonna be really fun when these two people meet. And I don't need to have anything to do with it. It's just gonna be interesting. When we meet a borrower who we think actually is originating an interesting type of credit, it just doesn't fit within our credit box. It almost feels like our obligation to tell one of our friends in the credit community who has a lending fund, that they should meet the founder, because it'll come back around like you said.

• 1:07:21Speaker 04

  Ollie, I think that's the Jewish mother guilt that we grew up in.

• 1:07:25Patrick O'Shaughnessy?

  Yeah.

• 1:07:25Speaker 06

  Well, thanks again, guys. This has been informative as always. Thanks for all your time.

• 1:07:29Speaker 04

  Thanks.

• 1:07:29Speaker 03

  Thanks for having us.

• 1:07:32Speaker 06

  Hey, everyone. Patrick here again. To find more episodes of Invest Like the Best, go to investorfieldguide.com/podcast. If you're a book lover, you can also sign up for my book club at investorfieldguide.com/bookclub. After you sign up, you'll receive a full investor curriculum right away, and then three to four suggestions of new books every month. You can also follow me on Twitter, at Patrick underscore Oshag, O-S-H-A-G. If you enjoy the show, please leave a quick review for us on iTunes, which will help more people discover Invest Like the Best. Thanks so much for listening.